Therol Inc. has no debt. Its invested capital generates $5 of earnings per share, and all these earnings are paid out as dividends.
a. Suppose that Therol's shareholders require a return of 10 percent on their investment in the firm. What is Therol's stock price if the firm's earnings per share stays at $5 and if its dividend policy does not change over the foresee able future?
b. Suppose that Therol pays out 60 percent of its earnings from existing invested capital and reinvests the remaining 40 percent in new plant and equipment, from which it expects a return of 10 percent. What would be the effect on Therol's stock price? Compare it with the stock price found in question (a) and explain.
c. What if the return on new plant and equipment is 15 percent instead of 10 percent? What is your interpretation of the difference in the stock price?